BNP Paribas AM: Downside protection strategies for a bear market

Innovation and a careful approach are needed to protect your portfolio from market downside threats from rising geopolitical and economic turbulence
  • Diversification becomes harder when inter-asset class correlations are high
  • Downside hedges can be costly
  • Using a volatility trigger can help limit bear market losses

For many investors, one of the first pieces of advice was to diversify your portfolios across multiple asset classes so that if one type of asset does badly, you still have all the others to help achieve what you want.

However, correlations between asset classes are at an all-time high, and look likely to remain so for some time yet. One key reason for this is that until recently, financial markets were still riding the recovery from the global financial crisis. Furthermore, there have been significant changes in return, risk and correlation profiles across asset classes so that higher risk asset classes have swapped places with lower risk ones.

One clear example: the US yield curve’s inversion. This in effect proclaimed that the market requires a higher return on a short-term investment than on a longer-term one. In short, it signalled near-term market turbulence.

So, diversification has not brought rewards over the last decade and has even hurt portfolio returns. In contrast, having concentrated holdings in developed markets, in broad market indices or in ETFs has been the winning strategy.

While we believe diversification remains important to building an effective, robust portfolio aiming at long-term goals, over the last 10 years of relatively low volatility, the reward for diversification has been less pronounced.

Read more about the most effective ways to protect portfolio investments in a downside market.